Journal
JOURNAL OF ECONOMIC THEORY
Volume 128, Issue 1, Pages 136-163Publisher
ACADEMIC PRESS INC ELSEVIER SCIENCE
DOI: 10.1016/j.jet.2005.12.012
Keywords
portfolio choice; robustness; model uncertainty; intertemporal hedging; detection-error probability
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I analyze the optimal intertemporal portfolio problem of an investor who worries about model misspec-ification and insists on robust decision rules when facing a mean-reverting risk premium. The desire for robustness lowers the total equity share, but increases the proportion of the intertemporal hedging demand. I present a methodology for calculation of detection-effor probabilities, which is based on Fourier inversion of the conditional characteristic functions of the Radon-Nikodym derivatives. The quantitative effect of robustness is more modest than in i.i.d. settings, because model discrimination between the benchmark and the worst-case alternative model is easier, as indicated by the detection-error probabilities. (c) 2006 Elsevier Inc. All rights reserved.
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